Best of the Week
Most Popular
1. US Housing Market House Prices Bull Market Trend Current State - Nadeem_Walayat
2.Gold and Silver End of Week Technical, CoT and Fundamental Status - Gary_Tanashian
3.Stock Market Dow Trend Forecast - April Update - Nadeem_Walayat
4.When Will the Stock Market’s Rally Stop? - Troy_Bombardia
5.Russia and China Intend to Drain the West of Its Gold - MoneyMetals
6.BAIDU (BIDU) - Top 10 Artificial Intelligence Stocks Investing To Profit from AI Mega-trend - Nadeem_Walayat
7.Stop Feeding the Chinese Empire - ‘Belt and Road’ Trojan Horse - Richard_Mills
8.Stock Market US China Trade War Panic! Trend Forecast May 2019 Update - Nadeem_Walayat
9.US China Trade Impasse Threatens US Lithium, Rare Earth Imports - Richard_Mills
10.How to Invest in AI Stocks to Profit from the Machine Intelligence Mega-trend - Nadeem_Walayat
Last 7 days
Facebook's Libra Crypto currency vs Bitcoin: Five Key Differences - 19th June 19
Fed May Trigger Wild Swing In Stock Index and Precious Metals - 19th June 19
How Long Do Land Rover Discovery Sport Brake Pads Last? - 19th June 19
Gold Golden 'Moment of Truth' Is Upon Us: $1,400-Plus or Not? - 18th June 19
Exceptional Times for Gold Warrant Special Attention - 18th June 19
The Stock Market Has Gone Nowhere and Volume is Low. What’s Next - 18th June 19
Silver Long-Term Trend Analysis - 18th June 19
IBM - Watson Deep Learning - AI Stocks Investing - Video - 18th June 19
Investors are Confident, Bullish and Buying Stocks, but… - 18th June 19
Gold and Silver Reversals – Impossible Not to Notice - 18th June 19
S&P 500 Stuck at 2,900, Still No Clear Direction - 17th June 19
Is Boris set to be the next Conservation leader? - 17th June 19
Clock’s Ticking on Your Chance to Profit from the Yield Curve Inversion - 17th June 19
Stock Market Rally Faltering? - 17th June 19
Johnson Vs Gove Tory Leadership Contest Grudge Match Betfair Betting - 17th June 19
Nasdaq Stock Index Prediction System Is Telling Us A Very Different Story - 17th June 19
King Dollar Rides Higher Creating Pressures On Foreign Economies - 17th June 19
Land Rover Discovery Sport Tailgate Not Working Problems Fix (70) - 17th June 19
Stock Market Outlook: is the S&P today just like 2007 or 2016? - 17th June 19
US China War - Thucydides Trap and gold - 16th June 19
Gold Stocks Bull Upleg Mounting - 16th June 19
Gold Price Seasonal Trend Analysis - Video - 16th June 19
Fethiye Market Fruit, Veg, Spices and Turkish Delight Tourist Shopping - 16th June 19
US Dollar Gold Trend Analysis - 15th June 19
Gold Stocks “Launch” is in Line With Fundamentals - 15th June 19
The Rise of Silver and Major Economic Decline - 15th June 19
Fire Insurance Claims: What Are the Things a Fire Claim Adjuster Does? - 15th June 19
How To Find A Trustworthy Casino? - 15th June 19
Boris Johnson Vs Michael Gove Tory Leadership Grudge Match - Video - 14th June 19
Gold and Silver, Precious Metals: T-Minus 3 Seconds To Liftoff! - 14th June 19
Silver Investing Trend Analysis - Video - 14th June 19
The American Dream Is Alive and Well - in China - 14th June 19
Keeping the Online Gaming Industry in Line - 14th June 19
How Acquisitions Affect Global Stocks - 14th June 19
Please Don’t Buy the Dip in Nvidia or Other Chip Stocks - 14th June 19
A Big Thing in Investor Education is Explainer Videos - 14th June 19
IRAN - The Next American War - 13th June 19
Boris Johnson Vs Michael Gove Tory Leadership Grudge Match Contest - 13th June 19
Top Best VPN Services You Can Choose For Your iPhone - 13th June 19
Tory Leadership Contest Betting Markets Forecast - Betfair - 13th June 19
US Stock Market Setting Up A Pennant Formation - 13th June 19
Which Stocks Will Lead The Cannabis Rebound? - 13th June 19
The Privatization of US Indo-Pacific Vision - Project 2049, Armitage, Budget Ploys and Taiwan Nexus - 12th June 19
Gold Price Breaks to the Upside - 12th June 19
Top Publicly Traded Casino Company Stocks for 2019 - 12th June 19
Silver Investing Trend Analysis - 12th June 19
Why Blue-Chip Dividend Stocks Aren’t as Safe as You Think - 12th June 19
Technical Analysis Shows Aug/Sept Stock Market Top Pattern Should Form - 12th June 19
FTSE 100: A Top European Index - 12th June 19
Gold Surprise! - 11th June 19
How Forex Indicators are Getting Even More Attention in the Market? - 11th June 19
Stock Market Storm Clouds on the Horizon - 11th June 19
Is Your Financial Security Based On A Double Aberration? - 11th June 19
What If Stocks Are Wrong About Interest Rate Cuts? - 11th June 19
US House Prices Yield Curve, Debt, QE4EVER! - 11th June 19
Natural Gas Moves Into Basing Zone - 11th June 19
U.S. Dollar Stall is Good for Commodities - 11th June 19
Fed Running Out of Time and Conventional Weapons - 11th June 19
Trade Wars Propelling Stock Markets to New Highs - 11th June 19
Best Travel Bags for Summer Holidays 2019, Back Sling packs, water proof, money belt, tactical - 11th June 19

Market Oracle FREE Newsletter

Gold Price Trend Forecast Summer 2019

Europe and Deflation Paranoia

Economics / Deflation Apr 30, 2014 - 12:41 PM GMT

By: Frank_Hollenbeck

Economics

There is a current incessant flow of articles warning us of the certain economic calamity if deflation is allowed to show its nose for even the briefest period of time. This ogre of deflation, we are told, must be defeated with the printing presses at all costs. Of course, the real objective of this fear mongering is to enable continued government theft through debasement. Every dollar printed is a government tax on cash balances.


There are two main sources of deflation. The first comes from a general increase in the amount of goods and services available. In this type of deflation, a reduction in costs, in a competitive environment, leads to lower prices. The high technology sector has thrived in this type of deflation for decades as technical progress (e.g., the effect of Moore’s Law) has powered innovations and computing power at ever-decreasing costs. The same was true for most industries during much of the nineteenth century, as the living standard increased considerably. Every man benefited from the increase in real wages resulting from lower prices.

The second source of deflation is from a reduction in the money supply that comes from an increase in the desire of the public or banking sectors to hold cash (i.e., hoarding).[1] An uncomplicated example will make this point clearer. Suppose we have 10 pencils and $10. Only at an equilibrium price of $1 will there be no excess output or excess money.

Suppose the production cost of a pencil is 80 cents. The rate of return is 25 percent. Now suppose people hoard $5 and stuff money in their mattress instead of saving it. The price of a pencil will be cut in half, falling from $1 to 50 cents, since we now have a money supply of $5 chasing 10 pencils. If input prices also fall to 40 cents per pencil then there is no problem since the rate of return is still 25 percent. In this example, a drop in output prices forced an adjustment in input prices.

The Keynesian fear is that input prices will not adjust fast enough to a drop in output prices so that the economy will fall into a deflation-depression spiral. The Keynesian-monetarist solution is to have the government print $5 to avoid this deflation.

Yet, this money creation is distortive and will cause a misallocation of resources since the new money will not be spent in the same areas or proportions as the money that is now being “hoarded” (as defined by Keynesians). Furthermore, even if the government could find the right areas or proportions, it would still lead to misallocations, since the hoarding reflects a desire to realign relative prices closer to what society really wants to be produced. The printing of money may actually increase the desire to hold cash, as we see today. Holding cash may be the preferred choice over consumption or investment (savings) when relative and absolute prices have been distorted by the printing press.

Of course, no one is really asking the critical questions. Why does holding more cash change the money supply, and why did the public and banks decide to increase their cash holdings in the first place?[2] Without fractional reserve banking, neither the public nor the banks could significantly change the money supply by holding more cash, nor could banks extend credit faster than slow-moving savings. The boom and ensuing malinvestments would be a thing of the past and, thus, so would the desire to hold more cash during the bust phase of the business cycle. If central banks are really concerned about this type of deflation, they should be addressing the cause — fractional reserve banking — and not the result. Telling a drunk that he can avoid the hangover by drinking even more whiskey is simply making the situation worse.[3] The real solution is to have him stop drinking.

According to the European Central Bank’s Mario Draghi,

The second drawback of low inflation ... is that it makes the adjustment of imbalances much more difficult. It is one thing to have to adjust relative prices with an inflation rate which is around 2%, another thing is to adjust relative prices with an inflation rate which is around 0.5%. That means that the change in certain prices, in order to readjust, will have to become negative. And you know that prices and wages have a certain nominal rigidity which makes these adjustments more complex.

Draghi is confusing the first source of deflation with the second. The recent low inflation in the Euro zone can be attributed primarily to a strengthening of the Euro, and a drop in food and energy prices.

Economists at the Bundesbank must be quietly seething. They are obviously not blind to the ECB’s excuses to indirectly monetize the southern bloc’s debt. Draghi’s “whatever it takes�� comment gave southern bloc countries extra time. Yet, little has been done to reign in the size of bloated public sectors. Debt to GDP ratios continue to rise and higher taxes in southern bloc countries have caused an even greater contraction of the private sector. Many banks in southern Europe are technically bankrupt. Non-performing loans in Italy have gone from about 5.8 percent in 2007 to over 15 percent today. And, the situation is getting worse.

Greece recently placed a five-year bond at under 5 percent which was eight times oversubscribed. This highlights the degree to which the financial sector in Europe is now dependent on the “Draghi put.” As elsewhere in the world, interest rates in Europe are totally distorted and no longer serve the critical function of allocating resources according to society’s time preference of consumption, or even reflect any real risk of default.

The ECB will likely impose negative rates shortly but will discover, as the Fed and others did before it, that you can bring a horse to water but cannot make him drink. QE will then be on the table, but unlike the Fed, the ECB is limited in the choice of assets it can purchase since direct purchase of Euro government bonds violates the German constitution. One day, Germany and the southern bloc countries, including France, will clash on what is the appropriate role of monetary policy.

Germany would be wise to plan, today, for a possible Euro exit.

Notes

[1] Keynesians view holding cash, and even holding savings in banks as “hoarding,” but properly understood, only the equivalent of stuffing money in a mattress is hoarding.

[2] Fractional-reserve lending is inflationary, thus contributing to inflationary booms. In turn, banks hold more cash when they fear a confidence crisis, which is also a result of the boom.

[3] Since inflationary fractional-reserve lending is a source of the problem, additional lending of the same sort is not the solution.

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.

You can subscribe to future articles by Frank Hollenbeck via this RSS feed..

© 2014 Copyright Frank Hollenbeck - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules